October 2014 - Page 2 of 2 - Bankers Anonymous

October 20, 2014June 30, 2016

More On Actively Managed Equity Mutual Funds

Lately I’ve taken to saying boldly and loudly to anyone who asks my opinion (and some who don’t!) that every academic study ever done on actively managed (high cost) mutual funds vs. passively managed index (low cost) mutual funds shows that, in aggregate, the actively managed funds under-perform the passively managed funds by approximately the difference in fees charged by actively managed funds.

That’s the central and ongoing conclusion of not just the first edition of Burton Malkiel’s A Random Walk Down Wall Street, but every updated edition since the book first appeared in 1973. Although Malkiel’s view has won the academic battle, still the combined marketing heft of the actively managed mutual fund industry has not yet conceded the war.

Investment strategist and and nationally syndicated columnist Scott Burns of Asset Builder – points out in this post yet another important article debunking the usefulness of actively managed mutual funds, when compared to their admittedly doughty but nevertheless more profitable younger siblings, index mutual funds.

If you’re curious to dip your toe into these ideas, I recommend starting with Scott Burns’ post, then move on to the article itself.

Please see related posts:

Book Review of A Random Walk Down Wall Street, by Burton Malkiel

Book Review of Investing Demystified by Lars Kroijer

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October 20, 2014October 20, 2014

Volatility in Stocks – That’s a Good Thing

A version of this post ran in the San Antonio Express News today.

bastrop_fire_as_stock_market_analogy — Bastrop Fire aftermath, 2011

The U.S. stock market got quite volatile last week, and I couldn’t be happier.
Let me explain why, by way of the analogy of the 2011 fire at Lost Pines State Park.

Scorched earth and equity markets

Two weeks ago, I drove with my family near Lost Pines Forest, the ground zero of a devastating forest fire in 2011 that Wikipedia tells me was the most destructive wildfire in Texas history.

I had passed through Bastrop just weeks after that fire on our way to College Station, and I remember how utterly desolate the roadside forest appeared. Just a terrible vista of charred chimneys, missing their houses. Blackened trunks perched on scarred ground.
Now, however, the ecosystem is roaring back.

Fire leads to new growth

A friend of mine who teaches biology at Trinity University in San Antonio — she studies grassland ecosystems in particular — confirms what you can observe now at Lost Pines. The incredible rate of regrowth of the Lost Pines Forest happens because of the devastating fire.
In many areas, grass and forest ecosystems depend on periodic fires to remain healthy. The fire spurs growth. No fire in the past leads to less healthy growth in the future.

bastrop_regrowth — Regrowth of scorched earch

The forest fire stock market analogy

Just like periodic forest fires keep ecosystems healthy for grasses, plants and trees, periodic market crashes keep stock markets healthy for you and me, as long-term investors.
I credit Morgan Housel at the finance website Motley Fool for introducing me to this idea first — that stock markets must crash periodically in order to provide a decent return for the rest of us.

We typically complain, or fret, about stock market volatility. But you know what? That’s the wrong approach. The crashes help repel other people’s money from the market, which allows us long-term investors to earn a positive return.

To be perfectly clear about what I mean with my analogy: We need markets to crash periodically in order for them to “do their job” for us, which is to provide a decent positive return on our long-term surplus capital.

This positive view of market crashes — the financial equivalent of devastating wildfires — is so counterintuitive to our way of thinking and talking about the stock market that it just may alter the way you view the peripatetic ups and downs of equity markets. I hope so. That’s the point of this post.

Now, how exactly does it work that crashes and volatility are the keys to a decent positive long-term return for you, the long-term investor?
Think for a moment what the investment world would be like if stock markets always stayed stable. Zero volatility. Zero crashes. And let’s say in that stable world that stocks initially returned an average of 6 percent per year.

The only rational thing to do, with a market that provided that kind of positive return and perfect stability, would be for everyone to empty their bank accounts and pour money into the stock market. If people felt safe, they would put all their money into the stock market.
That decision by everybody would raise the price of stocks so much that future returns on stocks would decline, to something much less attractive. Given perfect stability, the market would attract as much money as it could take until future returns would approach the returns of other stable, store-of-value vehicles, like bank accounts.

Which is to say, if stocks were completely stable, we would all buy them until they offered a roughly 0 percent future return, just like bank accounts.
But the fact that you can get burned in stocks is exactly why not everybody empties out their banks accounts to bid up the prices of stocks. This relative scarcity of stock market capital leaves space for growth, like a forest that’s been cleared by a fire.
Stocks, thankfully, are not stable. People don’t feel safe. And that’s a good thing.

Do you need your money back before five years? Don’t bother with stocks. You may get burned.

The fact that people who need their money back within five years shouldn’t go anywhere near stocks — due to volatility — is part of the reason why stocks provide longer-term investors with a return above 0 percent.

Without crashes, the stock market would attract too much money. The periodic crash is therefore not a failure of markets or a glitch in the system. On the contrary, the periodic crash — like the forest fire — is a key to the whole system working correctly.

Here’s the topsy-turvy — but nevertheless true — logic of the relationship between volatility and stock market returns: Total stability would lead to “pricing for perfection,” which in turn could be destabilizing when underlying companies and the economy failed to achieve perfection. A volatile market, by contrast, stays just unattractive enough for short-term and speculative investors to allow for predictable, positive, long-term returns for long-term investors.

Long live the forest fire! Long live the volatility!

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October 15, 2014October 15, 2014

This US History Sounds Marxist, And Also Basically True

Can something be basically Marxist and also basically true? Of course my answer is yes, because Marxism as a tool for analysis can sometimes be summed up as a ‘Follow The Money.’

As an economic and political system Marxism has – so far – been as awful a system as we humans can manage to create [possibly in a four-way tie with Fascism, Talibanism and whatever you’d like to call North Korea’s ‘Juche’ system.]

As political analysis, however, Marxism has much to lend to it. Primarily the view that we can understand major economic groups as sharing common interests that they will, in aggregrate, try to advance at the expense of other major economic groups. This article below strikes me as a largely accurate, Marxist, view of US History. Enjoy!

Defending Wealth in America article.

In other semi-related news, I’m slowly making my way through Piketty’s Capital. Very enjoyable so far, and I’ll do a review as soon as I can.

Please see related posts:

Inequality in America video

Book review of Plutocrats by Chrystia Freeland

TED talk of inequality from a Plutocrat

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October 13, 2014October 20, 2014

Do You Need An Investment Advisor? And Why?

A version of this post previously appeared in the San Antonio Express News.

Some friends of mine recently opened up investment accounts with a guy who is a salesman at a national insurance company. My friends also hired a “fiduciary” to review their investment plans. Finally, they consulted me, for free, on what to do with their investments because I’m a friend.

They seek answers to something nobody ever bothers to teach. They need financial advice. Who doesn’t?
Among the three sources they recently contacted, they will certainly hear quite a bit of possibly contradictory advice. In the long run, I got to thinking, do they also need to hire an investment advisor?
“Do you need an investment advisor?” is one of those evergreen questions for people who have managed to accumulate some investments.

The short, albeit possibly contradictory answer — given that I do not have an investment advisor myself — is: “Yes, probably.”
Following on the heels of that question, if the answer to the first question is yes, is: “What do I need an investment advisor for?”

I’m so glad you asked. And you’re not going to believe this, but I have very strong opinions on this question.
A good investment advisor should do two — and only two — things, and then stop.

Number one thing: Set up an investment plan for the client that has a reasonable chance for success at meeting the client’s goals, taking into account the client’s ability to save and invest. The plan should be so simple that all parts can be understood clearly by the client. The plan should run on auto-pilot (probably involving automatic paycheck or bank account deductions), and should rebalance on a low-frequency cycle (probably through new purchases, rather than sales).
All of this should be accomplished within two visits with the investment advisor.

Number two thing: When the market crashes — by the way, the only 100-percent guaranty in an investing life is that the market will crash, probably more than once, in a client’s 30-year investment cycle — the investment advisor is there to prevent the client from selling after the crash. Because when things get cheap you’re supposed to buy more, not sell.
Psychologically speaking, few of us can stomach the nausea of actually buying after the crash.

Ahem. Now, would all those reading this who made stock purchases in March 2009 please raise your hand?
Oh, really? All of you with your hands up are liars.
While we rarely have the sense to buy at the lowest point in the market, realistically a good investment advisor reminds us at least not to sell after the crash happens. The good advisor reminds us that we knew a crash would happen a couple of times in our 30-year investment cycle.
After the crash comes you don’t sell — you just keep on doing what you’re doing. If the advisor can prevent the panicked sale after the crash, the advisor is worth all the money paid to her over the years.

And that’s it. Anything else that an investment advisor does is probably too much, and the client may suffer as a result.

“But, but, but…..” I can already hear all of the investment advisors out there protesting.

But what about tax planning? And estate planning?
What about insurance products? Have you considered whole life versus term life insurance. Or can I interest you in a variable annuity?
But shouldn’t an advisor pre-screen some hedge funds and venture capital funds?
Want to hear about oil & gas leases? Master limited partnerships?
I’m pretty sure there’s real estate and mortgage refinancing to be done, no?
What about picking great stocks for a client?

financial_advisor — If your financial advisor was a stock-photo robot, he should look like this

But what should I know about precious metals, agricultural commodity futures, and that new project finance deal in Ghana?
I also once read something about sector rotation? And then there’s value vs. growth? And biotech, and countercyclical consumer products!
What about anticipating the Fed, trading ahead of new data releases, getting in early on the next hot trend, or black-box trading and currency hedging?
Look, I agree — finance can be endlessly fun and interesting, and these are all great areas for a broker or investment advisor to get into because they produce wonderful opportunities for additional fees, commissions, portfolio churn and opacity. In most cases, however, they just don’t happen to produce wonderful results for clients.
If you need insurance or tax planning, by all means hire an expert. But a good investment advisor does not necessarily serve her client by brokering all these products.

To sum up:
Do you know how to set up what I describe above as “the number one thing” all on your own? If not, you probably need an investment advisor.
Second, do you know — beyond a shadow of a doubt — what you will do when the market crashes? Are you sure? If not, you probably need an investment advisor to hold your hand — that itchy-to-sell trigger-finger hand — to prevent you from selling.

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October 6, 2014October 6, 2014

More on Subprime Lending Policies from the Feds

Editor’s Note: A (shorter and less conversational) version of this post appeared earlier today in the San Antonio Express News.

An official from the Department of Housing and Urban Development (HUD) responded last week to disagree with my article two weeks ago in which I claimed that Secretary Julian Castro supported subprime lending, in his speech about HUD priorities September 16th.

We had a lovely chat.

What Castro said

What Castro actually said in his speech is the following:

“According to the Urban Institute, the average credit score for loans sold to GSEs [*which stands for ‘government sponsored entities,’ shorthand for Fannie Mae, Freddie Mac, and Federal home loan banks] this year is roughly 750. Currently, there are 13 million people with credit scores ranging from 580 to 680. Many of them are ready to own, but are being left out in the cold. The truth is that the dream of homeownership is out of reach for too many Americans. This has to change.”

I interpreted ‘this has to change’ to mean he advocated greater subprime lending. Castro specifically included credit scores that meet the ‘subprime’ definition, even though he did not use the phrase ‘subprime lending,’ probably because after the 2008 crisis ‘subprime‘ became a dirty word.

Definition of subprime

Banks sort mortgage borrowers according to their FICO scores, a personal-credit score based on past borrower behavior.

A 720 score and above is considered “Prime.” A 680 FICO and below is considered “Subprime.” To fill out the middle part of the scale, a 680 to 720 score is generally considered “Alt-A,” an in-between designation of credit worthiness.

Reasonable people can quibble on the exact FICO boundaries between Prime, Alt-A, and Sub-Prime, and banks can make their own determinations of the ranges for their own lending purposes, but 680 and 720 are the traditional boundaries separating the three segments of the mortgage market.

To make the definition completely clear: If you have a 680 FICO or below, to name one FICO score Castro mentioned in his speech, you have a history of not paying some of your debts on time. If you have a FICO score closer to 580, to name the other score Castro mentioned, you have a history of not paying most of your debts on time.

There’s no other way to have a 580 to 680 FICO than to have missed debt payments.

This doesn’t mean you’re a bad person. Nor does it mean you should never own a home. It just means that your past payment behavior suggests elevated future risks of not being able pay for your debts, such as a mortgage.

Most importantly, with a FICO of 680 or below, you will only qualify for a subprime mortgage from your bank.

So that’s why I think I made the reasonable inference from Castro’s speech that “This has to change” indicated a government preference for more subprime lending.

“Fair Access”

The HUD official did not agree with my description.

When I pointed out to the HUD official that historically 20% of subprime borrowers get into payment trouble on their mortgages, the official said I should focus instead on the 80% of borrowers who do not get into trouble, the ones who pay their mortgages on time.

Shouldn’t those 80%, he argued with me, have ‘fair access’ to the dream of homeownership?

Yes, of course. Nobody could ever disagree that people should have ‘fair access.’

He argued with me that the point of HUD policy is to ‘remove the barriers’ to the 80% of borrowers with bad credit who will pay their mortgages on time.

Removing barriers also seems great to me.

The much more difficult task is to figure out what ‘fair’ means, and what ‘access’ means. And what are the lending barriers that HUD wants to remove when it comes to borrowers with FICO scores below 680?

I would argue, and I did to Castro’s colleague at HUD, that the focus on positive outcomes for the 80 percent of subprime borrowers who pay their mortgage on time kind of finesses the point, by shifting the conversation away from the other 20 percent who will not be able to pay their mortgage.

And, in my opinion, the point is whether federal government policy should put its thumb on the scale to increase access to a market in which 20 percent of borrowers could lose their home due to non-payment on their mortgage.

In the end, however, I should not have worried too much because I don’t think the policies advocated by Castro will do much.

Actual Policy

It turns out, according to both the official and the follow-up materials his office sent me, that what Castro and HUD mean by “this has to change” is something pretty mild.

They mean a three-part program of
1. Encouraging borrower counseling
2. Clarifying lending standards (with an updated FHA Handbook!)
3. Analyzing additional data on mortgage lenders and sample mortgages

That all seems reasonable. In addition, this isn’t going to open the floodgates to increased subprime lending anytime soon.

Which leads to an interesting – albeit convoluted – ‘lets-agree-to-disagree’ point between myself and the HUD official.

Whereas I don’t think HUD should encourage more subprime borrowing and he does, I don’t think the federal government’s policies will have much effect, and he does.

So we’re both happy. I guess?

We all do this

Let me shift away from using the words “Castro” and “HUD” and “Federal Government” now to make this less personal, and frankly so it doesn’t seem like I’m politically attacking San Antonio’s golden child.

I’m going to make the decision-maker in the following sentences simply “We.”

Because I think we all do this.

As a society we are in the habit of wanting two contradictory things at the same time when it comes to banking policy, even though they are somewhat incompatible with each other.

For equality-of-access reasons we want banks to lend to more people, especially the neediest people, despite the fact that such lending is historically quite risky for both the bank and the borrower. The borrower, who we want to help, can wind up without a home, in bankruptcy, and with further wrecked credit. Banks can lose money, which – when this happens systemically – can crater an economy, as happened in 2008. In these indirect ways, therefore, increased subprime lending is quite risky for society.

At the same time – or shortly thereafter, when 20% of these mortgage loans go bad, as expected – we want to punish banks for lending to the neediest people, “when the banks should have known better,” or when a loan to a needy person ends up looking predatory because either the rate is very high, or the collateral (the home) was seized in foreclosure, or both.

So we can all want these contradictory things at the same time, but I think we can also acknowledge that it’s all kind of hypocritical, no?

Please see related posts:

HUD Policy – The Good And Bad So Far

Mortgages Part VIII – The Cause of the 2008 Crisis

Mortgages Part V – Good Debt or Dangerous Drug?

Book Review of Edward Conard’s Unintended Consequences

Audio Interview Podcast – Mortgage Originator Explains the Crisis

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October 3, 2014

SIGTARP is Back! Be Mad Again. And Happy

My favorite government watchdog of all time, SIGTARP[1], The Norse God of Financial Accountability, recently published another great critique of Treasury’s handling of TARP rules, this one about executive compensation within bailed out firms.

SIGTARP is a favorite of mine because they point out mistakes and errors with the TARP program. At its best, SIGTARP represents to me a hopeful sign that our federal government can learn from its mistakes.

In a time of deep cynicism about how “Washington is broken,” the Special Inspector General[2] role fills me with optimism. If our federal government is strong enough to weather pointed and non-partisan critiques from within, then we’ve got a pretty robust system.[3]

Which makes me happy. Ok, now back to the latest report.

Pay Czar blew it

SIGTARP reports that the Treasury department – and in particular the “Pay Czar”[4] put in place to limit executive compensation at bailed out firms – pretty much blew it.

Here’s what happened in simplest terms:

In 2009, Obama and then Treasury Secretary Geithner announced that firms that took TARP bailout money would be subject to rules about how much they could pay their top 25 executives.

This made and makes sense because

When you take public money to save your firm, it’s a bit nasty to then turn around and send that public money out the door for private compensation in the form of salaries and bonuses. Which is EXACTLY what happened in 2008 with bailed out Wall Street firms, all of whom took TARP money, and then paid bonuses to their employees.
At a time of deepening economic malaise, the ‘optics’ of bailed out executives taking big bonuses while Main Street folks lost their jobs and homes after earning 1/300^th of the compensation seemed a bit, well, unfortunate.
Geithner claimed that excessive executive compensation actually contributed to pre-crisis risk-taking. I don’t know if really buy this, but anyway, it was a theory of his that became part of the justification for limiting compensation.
Restricting executive compensation should incentivize top executives to pay back their TARP money early, in order to return to the good old days of unrestricted compensation awards for themselves. Thus aligning taxpayer public interests with top executives’ private interests, as seems to have happened, according to Citigroup and Bank of America executives later interviewed by SIGTARP.

The Pay Czar rules said:

The top 25 highest-paid executives at each firm should not receive cash compensation above $500K without special permission from the Pay Czar. Which permission, it turned out in retrospect, was not hard to get, as we read in the SIGTARP report.
Compensation above $500K would have to come in the form of long-term restricted stock in the bailed company. Which is frankly not that onerous a rule, and probably ironically served to further enrich some executives who received huge stock awards at depressed 2009-2011 share prices. There’s a long and distinguished tradition of excessively compensating executes through share awards, as I’ve written about before.
Compensation for the next 75 most highly-compensated employees had to be made in reference to average payments for comparable employees in similar jobs in the market. They couldn’t, or shouldn’t, be paid more than the average in the market without special permission. Which, again, makes sense because why are you being paid more than average when your freaking firm just got its ass bailed out with taxpayer money?
These restrictions would stay in place until firms repaid their TARP bailout money.

buy_our_shitty_cars — My favorite GM bailout poster

My view on these rules, and what happened

When you look at these rules in aggregate, they do not seem to me restrictive at all. This is not written by some “Socialist Gubmint that wants to attack Capitalism and END OUR FREEDOMS.”

On the contrary, the only reasonable view of these rules, in my opinion, is that these rules were practically written by the bailed out firms themselves. Which, if you believe in at least the cognitive capture of the leaders of our regulatory system[5], you could plausibly argue they did write the rules.

Despite that, as SIGTARP reports, the Pay Czar totally failed to enforce even these executive-friendly rules, especially with some of the final TARP bailout companies, GM and Ally Financial.

sigtarp_norse_god_of_financial_accountability — SIGTARP: Norse God of Financial Accountability

The main points of the SIGTARP report, summarized for your reading pleasure (and to make your head explode with anger if you think about it too hard)

General Motors (the pension-payments company that also happens to make cars that people don’t buy) and Ally Financial (formerly GM Acceptance Corp, the auto-finance branch of General Motors) were the last of a special group of extraordinary bailout firms[6] to pay back TARP money.
Both firms’ executives made the case to the Pay Czar that restrictions on their executive compensation were counterproductive, because they were trying to be “competitive in the market” in order to pay back TARP money. The Pay Czar, according to SIGTARP, found this entirely self-serving argument persuasive when bending the compensation rules for GM and Ally.
This happened, despite the fact that other TARP firms rushed to pay back TARP money, in order to loosen up their pay restrictions. In other words, the restrictions on executive compensation effectively accelerated repayment as intended for most bailed companies, but the Pay Czar later forgot this and felt like the rules should be bent in order to accelerate the repayment to taxpayers. The Pay Czar got this backwards.
GM and Ally Financial in particular cost taxpayers quite a bit of money in the final accounting. Instead of collecting the repaid TARP money, the federal government sold its stakes in the companies to public markets at a loss – $11.159 B for GM, $1.763 for Ally. That didn’t stop the firms from getting the compensation rules bent repeatedly for them prior to these final accounting of losses.
Both companies – as detailed in the SIGTARP report – managed to get pay raises, exceptions to the $500K limit, exceptions to long-term stock restrictions, and ignored policies and procedures put in place by Treasury regarding payment restrictions.
Restrictions on executive compensation actually got looser and looser in the 2009 to 2014 period, even as expected losses at GM and Ally Financial became clearer and more likely.
Treasury approved at least $1 million in pay for every top 25 employee at GM and Ally in 2013, despite the supposed rules in place to guide the Pay Czar, and prior to the ‘repayment’ of TARP through the government sale of shares to public markets.

In Conclusion

The 2008 crisis and aftermath makes different people mad for different reasons.

For me, the most egregious part of the whole episode has been the enjoyment of private profits with the benefit of public bailout funds before, during, and after 2008.

I love SIGTARP for making available the details on this egregiousness.

I’m mad, but I’m happy we have a paper trail to help me know exactly what I’m mad about.

Please see related posts:

Book Review of Neil Barofsky’s Bailout: The Inside Account of How Washington Abandoned Main Street While Rescuing Wall Street

In Praise of SIGTARP – Norse God of Financial Accountability

SIGTARP I – Truth in Government

SIGTARP II – Biggest Banks Still Too Big To Fail

SIGTARP III – The Citigroup Bailout

SIGTARP IV – What Small Banks Are Going Under Next?

SIGTARP V – My Front Row Seat to the AIG Debacle

[1] SIGTARP stands for the Special Inspector General for the Troubled Asset Relief Program. Created by Congress, the SIGTARP periodically publishes reports on how TARP money was spent and misspent, investigations into criminal activity around TARP, and makes policy recommendations to Treasury about ways to do things better, or what it did wrong. I <3 SIGTARP.

[2] There are several Special Inspector Generals for a variety of important policy morasses in the federal government, including for “Iraq Reconstruction” and “Afghanistan Reconstruction. A big part of their role is to tell us exactly what got screwed up, how the money got wasted, And that’s a good thing.

[3] I mean, we can all get ‘mad at Washington.’ But the fact is that Russia and China are not robust enough systems to handle an internal critique like a Special Inspector General. They are too fragile and they know it. We are anti-fragile.

[4] The Pay Czar is actually technically known as the Office of the Special Master for TARP Executive Compensation, shortened to OSM in the SIGTARP report. I like the phrase Pay Czar better, however, so I’m going to stick with it for the rest of this post. The first Pay Czar was Kenneth Feinberg, previously in charge of the 9/11 Victims Compensation Fund, and later the BP Oil Spill Fund, and Boston Marathon Bomb Victims Fund. Feinberg was later succeeded by Patricia Geoghegan, about whom I know nothing.

[5] ‘Cognitive capture’ is shorthand for my favorite theory I learned from from Chrystia Freeland’s Plutocrats, which I reviewed earlier.

[6] The Treasury Department especially tracked the ‘exceptional’ TARP bailout money given to AIG, Citigroup, Bank of America, Chrysler, Chrysler Financial, GM, Ally Financial (formerly GMAC), because these seven firms were especially FUBAR in 2008, meaning the amounts were really high and the risk of taxpayer losses were also exceptionally high.

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Month: October 2014

More On Actively Managed Equity Mutual Funds

Volatility in Stocks – That’s a Good Thing

This US History Sounds Marxist, And Also Basically True

Do You Need An Investment Advisor? And Why?

More on Subprime Lending Policies from the Feds

SIGTARP is Back! Be Mad Again. And Happy

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